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12/02/2013 @ 12:47PM7,479 views

Is The Leveraged Loan Market Signaling Trouble Ahead?

Seal of the United States Office of the Comptroller of the Currency, part of the Department of the Treasury. The design is the same as the Treasury seal with a Comptroller of the Currency inscription. (Photo credit: Wikipedia)

Depending on your point of view the leveraged loan market is either the fast track for yield hounds or a slippery slope that’s getting a lot muddier.

Actually, it’s both.

Here’s why investors are falling over themselves buying up these relatively high yielding investments and how their grab for yield could cause the loan market to fall on its face.

Leveraged loans are loans taken out by less than investment grade companies. Generally, these loans result in a substantial increase in the borrower’s leverage ratio.

According to the Office of the Comptroller of the Currency “industry benchmarks include a twofold increase in the borrower’s liabilities, resulting in a balance sheet leverage ratio (total liabilities/total assets) higher than 50 percent, or an increase in the balance sheet leverage ratio more than 75 percent.”

The OCC broadly considers a leveraged loan to be a transaction where the borrower’s post-financing leverage, when measured by debt-to-assets, debt-to equity, cash flow-to-total debt, or other such standards unique to particular industries, significantly exceeds industry norms for leverage.

Loans issued by banks and other financial intermediaries are used to fund mergers and acquisitions, equity buyouts, refinancing, recapitalization, expansions and to increase shareholder returns and monetize perceived “enterprise value” or other intangibles.

Borrowers pay a floating rate, usually priced off LIBOR, and loans are collateralized by first and second liens on company assets.

That’s good news for investors in leveraged loans. If interest rates rise investors yields rise too. If there are defaults, investors are first or second in the collateral selloff line.

But the grab for yield in the interminably long low interest rate environment engineered by the Federal Reserve is flipping the leveraged loan market on its head once again.

So far this year, up to November 14th, $548 billion worth of leveraged loans have been issued, which is more than the $535.2 billion issued in 2007, the previous peak year.

That’s not alarming. What is alarming is that more than half of this year’s issuance has been “covenant-lite.” That’s more than double the 2007 peak year level.

Covenant-lite, or cov-lite, refers to the lack of traditional covenants embedded in loan contracts that lenders usually demand. Because the demand for higher yielding investments is so strong, borrowers aren’t giving lenders and investors protections such as limiting how much total borrowing or leverage they will take on. Borrowers aren’t letting lenders trigger protective action if cash flows weaken, or if other important metrics of corporate balance sheet health are breached; and in many cases aren’t even letting lenders dig into their financials.

It’s become a giant buyer-beware bazaar.

And about that collateral. Lenders are increasingly issuing loans backed by second liens.

Demand for second lien leveraged loans is so high 46% of transactions this year have been issued with relaxed covenants and fewer guarantee provisions. That’s triple 2012 percentage of second-lien cov-lite leveraged loans. In 2007 only 14% of all leveraged loan volume was second lien loans.

So far investors have been happy with their leveraged loans and borrowers have been in serious party mode.

What investors need to do is keep an eye on rising interest rates. While they benefit by increased returns if rates rise, borrowers could come under intense pressure to fund loan payments or refinance outstanding debt in a rising rate environment.

As far as collateral, investors are better off in loans where borrowers have higher levels of unsecured debt. High levels of unsecured debt leaves more collateral for first and second lien protected lenders.

It’s not too late to invest in leveraged loans, but some ominous shadows are growing.

To be safe investors should only invest in the most liquid leveraged loan vehicles where they can exit with relative ease should price declines eclipse rising coupons.

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